Explainer: why India’s central bank is clamping down on FX arbitrage

India's central bank has moved to shore up the rupee with a sweeping set of emergency measures,like capping banks' currency positions, and banning rupee non-deliverable forwards, as the currency buckles under the weight of surging oil prices and the heaviest outflow of foreign capital from emerging markets in years.

Why the RBI acted

The rupee fell nearly 4% in March alone, compounding losses of roughly 4% over the preceding twelve months.

Higher oil prices have widened India's current account deficit while foreign funds have accelerated their exit from Indian assets, eroding the external buffers that had previously cushioned the currency.

The Reserve Bank of India said on Tuesday it was also taking steps to crack down on speculative trading.

The intervention measures

The RBI moved in two stages — on March 27 and April 2 — deploying a package of crisis-era tools.

Banks' net open positions in the rupee have been capped at $100 million, sharply down from a previous limit of up to 25% of regulatory capital.

The central bank also banned the issuance of rupee non-deliverable forwards for both domestic and foreign clients, a move that directly targeted the offshore market where speculative pressure had been building.

The 'rupee basis' trade and how it backfired

One of the most actively traded arbitrage strategies in the India-dollar space — the so-called "rupee basis" trade — turned sharply against its practitioners.

The trade involved shorting rupee non-deliverable forwards while holding long positions in onshore forwards, on the basis that offshore NDF rates would trade at a premium to onshore levels.

When the spot rate fell on Tuesday, the trade produced the opposite of its intended effect: it intensified dollar demand, amplified selling pressure on the rupee, diluted the impact of the RBI's intervention, and raised fresh questions about the depth of the central bank's foreign exchange reserves.

Banks — state-run, private, and foreign — had accumulated combined exposure of between $30 billion and $40 billion in such positions, much of it built up since the Iran conflict intensified.

Impact on banks and hedging costs

The ban on rupee NDF issuance has forced a sudden unwinding of hedging positions held by banks and corporates, raising the cost of cutting risk exposure at a moment when losses are already mounting.

The differential between onshore forward rates and offshore NDF rates determines the cost of unwinding those positions, and a widening spread could amplify losses further.

The RBI's tighter rules on leveraged basis trades are also expected to widen the gap between yields on Indian domestic sovereign bonds and their offshore equivalents.

The rupee may see a near-term bounce as the unwinding of basis trades forces banks and traders to sell dollars in the onshore market.

However, the measures risk isolating India's onshore market and pulling it further from the RBI's own stated objective of integrating the NDF and onshore currency markets.

The central bank's intervention capacity will continue to be tested so long as oil prices remain elevated and foreign capital outflows persist.

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